Definition & Meaning:

Instead of actually buying or selling the ownership of a financial asset (like stock in a company, currency, bonds etc...) or a commodity (e.g. gold, oil, wheat etc...) traded on an exchange, you can make an agreement in a contract with a third party (often a large financial organisation) to do something connected to a financial asset or commodity in the future. This could be to buy or sell a specific quantity of a financial asset at a specific price at a specific point in the future. These contracts are called 'financial derivatives' or simply 'derivatives'.

There are numerous different types of derivative contracts (like futures, put options, call options, swaps etc...) and they are often used by the people who use them to limit potential losses (referred to as 'hedging') when investing their money in financial securities.

For example, you buy 10,000 shares in Meta. You hope that in the future that the price for those shares goes up. However, you are very cautious, so in addition to buying those shares, you buy a derivative contract (called a put option) through your broker allowing you to sell those 10,000 at a specific price (say the price that you paid for them) in a year's time. Although you have to pay a fee to buy the derivative contract, if the price of Meta's shares falls a lot, you can exercise the contract and substantially reduce your losses.

These contracts are increasingly being used not just to hedge, but also to speculate on future changes to the price of financial securities.

Many (but not all) of these derivative contracts can also be freely traded between investors/traders before they expire or are taken up. As a result of changes in the market value of the financial asset they refer to, the value of derivative contracts varies depending on how potentially profitable they are for the person owning them.

If, for example, you have a contract to buy stock in a specific company at a specific price at a specific time in the future (in a futures contract), and the price of that stock is doing a lot better than anyone would have predicted at the time of creating/writing the contract, then that contract is seen as more profitable and its value would increase as a result. If the reverse happens, then its value would decrease.

Pronunciation:

Click to hear financial derivatives

Also Called:

Derivative Contracts, Derivative Instruments.

Related Vocabulary:

Futures, Put Options, Call Options, Swaps.

Exercises:

To learn more vocabulary connected to financial trading, you can do our free online exercise on types of financial derivatives.